Should we be shouting, 'Encore, encore'?

Jan 1st, 2000

2000 probably won't be a repeat of the 1999 boom in the photonics industry. But don't worry.

In February 1998, SoundView published its first industry report on photonics for investors. We were promoting photonics as an area we believed would produce great returns in the years ahead. We described the efforts of a couple dozen companies that were either well established in the sector or that seemed to be doing leading-edge development work. At the same time, we attempted to describe the devices the companies made and their functional capabilities. To many of you readers, this stuff would have been old hat, but to our audience, what we were talking about was a completely different language.

We placed what we'll call a cute tag line on the report, "Ride the Wavelength." Our purpose in doing so was to send a message that we believed the photonics industry represented more than just a nice trade, but also a real investment opportunity. When 1998 drew to a close, the group certainly had been interesting, but the spectacular rise and fall of CIENA tied to the aborted Tellabs merger and the collapse of Corning's fiber business in part precipitated by the global liquidity crisis, dampened the group's performance. So we had more of a choppy start than a wave.

We nonetheless stuck with our story in 1999, and the choppy start turned into a tsunami. As we wrote this column, SoundView's Photonics Index had risen 258% compared to the overall SoundView Technology Index at 68%. The S&P 500 Index was on a different radar screen altogether, up about 12%. The question we are asked lately, of course, is, what now? The answer for the industry is probably easier than it is for the stocks of the various industry participants.

We believe 2000 will be another great year for the industry. The public component companies such as JDS Uniphase, SDL, and E-TEK Dynamics have done a phenomenal job boosting capacity and bolstering their product lines, sowing the seeds for continued strong sales growth. The system companies seem to be moving to either next-generation products or new classes of products. Sycamore for instance, with the SN 8000, is attacking the ultra-long-haul DWDM market with a platform that offers more granularity in the speed of the pipe in addition to the greater reach of the system. In the new markets category, CIENA with CoreDirector is moving into the switching market from its early offerings in long-haul point-to-point DWDM systems.

The coming year will fall short of all-optical networking; however, it will be a year when carriers will be given the tools to get far greater functionality from DWDM than we have seen before.

As for the stocks of the companies, our feelings are more mixed. The dilemma we believe investors will face in 2000 is looking at a business environment that is very healthy and reaching a comfortable conclusion that new buyers will pay still higher prices for the shares after the phenomenal moves of 1999. Some companies will have developments that are important enough that they will support still higher prices during 2000. We believe that JDS Uniphase may end up in that category. Sycamore Networks, on the other hand, may knock the cover off the ball in 2000. Yet, because investors were so generous in what they were willing to pay for the shares in advance of the company's real revenue opportunity in 1999, the company may do well just to hold its ground from a share-price perspective over the course of 2000.

We believe the key to successful investing in the photonics sector in 2000 will be selectivity and good timing. In most years, the market gives you a chance to buy the shares of very good companies at a relatively attractive price. If we looked back at 1998, the global-liquidity crisis sent fear through the marketplace and had an impact on Corning's business. We knew that Corning would emerge from the crisis in a strong position, but when fear creeps into a market, everyone is afraid to fight the trend. Well, if you fought the trend in the case of Corning in the late fall of 1998, you may have tripled your money in the subsequent year.

Investors were not treated to a similar opportunity in 1999 with the photonics companies. The year was a one-way ride up, and while we are not predicting anything as dramatic as 1998's global-liquidity crisis in 2000, it is an election year and there is no incumbent we can bet on for a repeat term, so we have uncertainty. Uncertainty is the enemy of financial markets, and we would guess that the presidential election will create periodic concerns that may give investors an opportunity to buy shares of the optical component and system companies at more attractive prices than exist now.

We mentioned selectivity as another key to 2000. We said during the course of 1999 that we believed it was too soon to pick winners and losers in the optical-component sector. We would argue that during the course of 2000, the shortage environment that fueled enthusiasm for any company that sold anything into the market in 1999 will give way to a more-competitive environment. It would be premature to assume that it will be a level of competition that will create major industry fallout, but given high valuations in the group, it will likely create periods of concern for the affected companies.

We believe, for instance, that the major impetus for JDS Uniphase stepping beyond its exclusive joint venture with Optical Coating Laboratory was to put in place a singular management focus on solving the shortage of thin-film-filter-based WDM devices. That solution might come from greater productivity in the manufacturing of these devices, but it may also come from hybrid devices that are a blend of technologies. For companies like NetOptix that caught the attention of investors because they were attempting to address the shortage of thin-film filters, this situation might set in motion forces that will say it is not good enough to be in a thin-film-filter manufacturing business.

There is another kind of selectivity: focusing on new technologies. We hear a lot about planar devices or optical devices that have some degree of integration as part of their story. This is just one example. What we believe is that in 2000, investors will be treated to a new crop of companies that will represent different opportunities. As 1999 drew to a close, SoundView had the opportunity to be one of the underwriters of Finisar's initial public offering. Finisar brought a completely different optical-product portfolio aimed at the Gigabit Ethernet and Fibre Channel markets. We believe the company's unique profile will be an asset to the story and the stock in 2000. We also believe there will be other similarly unique initial public offerings in 2000.

So will there be an encore? We do not believe 2000 will be a repeat of 1999. It is rare in the investment business to have repeats of the kind of year that we witnessed in photonics last year. Look at Amazon in 1998. It and many of the other Internet stocks had remarkable years, just like the photonics sector did in 1999. They had another remarkable business year in 1999, but depending on when you bought Amazon's stock, you could have done as well as doubling your money and as badly as having it cut in half. We expect that kind of environment in 2000.

Kevin Slocum is a managing director and communications research analyst for SoundView Technology Group (Stamford, CT). He has more than 18 years of financial industry experience, including equity research, sales, and analysis. He can be reached at (203) 462-7219 or kslocum@sndv.com.

Robert Mandra is an associate in investment banking with SoundView Technology Group (Stamford, CT). Previously, he was an optical engineer with MIT Lincoln Laboratory for nine years. He can be reached at (203) 462-7361 or rman dra@sndv.com.